22 Important Investing Terms Everyone Should Know

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On this blog, I encourage you to understand how the world works and to take control of your financial destiny. If you want to become a Do-It-Yourself Investor, you should understand all these investing terms and more!

Mutual Fund

Is a collection of investment assets such as stocks, bonds, other securities or other funds which are managed by a professional manager or investment company. A mutual fund typically focuses on a specific investment type and pools together money from a large group of investors. A mutual funds is an easy way for an individual investor to buy into diversified portfolios and get access to professional management. Management and administrative fees are usually levied on your holdings in a mutual fund.

Index Fund

Is a type of mutual fund that is structured in such a way to match or track a prominent market index such as the Standard and Poor’s 500 index (S&P 500) or the Dow Jones Industrial Average (DJIA). An index fund is set up not to beat the market index but instead to replicate its performance. Advantages of an index fund include ease of management, lower portfolio turnover and less operating costs. Management fees are also much less. Investors in index funds expect to make market returns which is often more than most investors make year in and year out.

Stocks

Refers to a share in the ownership of a company. When you own a stock in a company, it means that you are one of its shareholders and have a claim to the company’s dividends and voting rights. You can also make money from price appreciation by selling your stocks (shares) when the price per unit goes up.

Bonds

Is a debt security. Examples include municipal bonds, corporate bonds, savings bonds, Treasury bills, etc. When you buy a bond, you are essentially lending money to the borrower (bond issuer) with the hopes of generating income from interest payments (coupon) during the life of the bond and getting the principal (face value of the bond) back at the maturity date. The farther away the maturity date, the higher the rate of interest a bond will pay.

Exchange Traded Funds (ETFs)

Is similar to an index fund, however, ETFs trade like stocks on a stock exchange. This means that they can experience price changes and can be bought and sold throughout the day just like stocks. Advantages of trading in ETFs include flexibility in buying and selling, lower expense ratio and opportunities for diversification.

Simple Interest

Is interest calculated on the original amount and does not include interests on any interest already earned. For example, 10% annual simple interest on $1000 (10% x 1000) is $100 for year 1 and remains $100 for year 2. The $100 interest earned in year 1 is not taken into consideration when computing the simple interest for year 2 and so on.

Compound Interest

Interest is calculated on the initial amount (principal) and also on the accumulated interest earned to date. Say you make a $1000 investment that earns 10% returns per year. For the first year, interest (simple) is $100 (1.e. 10% x $1000). Assuming returns are re-invested, for the second year, returns (interest) earned will be $110 (i.e. 10% x $1100) and so on. The rate of growth is now much higher than with simple interest. Legend has it that Albert Einstein once referred to compound interest as the most powerful force in the universe. It can significantly multiply your investments over time and can so the same with debt. Compound interest is an investment miracle and is one of the main strategies for building wealth.

Time Value of Money

Means that money on hand today is worth more than that same amount of money in the future. This is based on the premise that money on hand today can be put to work to earn interest and as such will be worth more than the initial value at some point in the future. So, $10 today is worth more than $10 in a year’s time. This is why some people say “Time is money.”

Bear Market

Is a market condition where securities prices are falling because sellers (bears) have overwhelmed buyers (bulls) and the market outlook is pessimistic (bearish).

Bull Market

Is a market condition where securities prices are rising because buyers (bulls) have overwhelmed sellers (bears) and the market outlook is optimistic (bullish).

Long Position

An investor buys a stock or security and holds it with the hope that the price will rise.

Short Selling

Trading technique in which a trader sells a stock/security that they have borrowed through their broker with the expectation that the stock’s price will decline and they can then buy the stocks back at a lower price, return the stocks to the lender and keep the difference as profit. It is a very risky technique and not for the faint of heart.

Diversification

Is a risk management technique in which you spread your investments over different asset classes (stocks, bonds, commodities, real estate, currencies) so as to reduce the exposure you have to any one asset and reduce the risk of your entire portfolio. Diversification may help to prevent against total loss if the market experiences an upheaval.

Asset Allocation

Is a strategy utilized in portfolio diversification in which an investor spreads out their investments over a variety of asset classes. The proportion of funds invested in each asset class is reflective of the risk appetite/tolerance, goals and time frame for investing set by the investor.

Risk Tolerance

Is the amount of financial risk or uncertainty an investor is willing to take. Risk tolerance may be influenced by an investor’s background, age, investing horizon, financial capacity, investing knowledge and many other factors. On the scale of risk tolerance, an investor may be very risk averse or may be risk loving. A risk averse investor prefers a conservative investing approach with limited risk and return. You can assess your risk tolerance here by completing a risk profile questionnaire like this one by Vanguard Canada or this one by Merrill Lynch.

Financial Risk

Is the uncertainty of returns and the potential for financial loss. Every investment carries a level of risk, but some investments are riskier than others.

Risk-Return Trade off

In investing, there is a relationship between risk and return. The higher the risk, the greater the potential for higher returns or larger losses. The lower the risk, the greater the probability of lower returns or smaller losses (comparatively).

Market Volatility

Rate of change in the price of a stock or security. Stock prices normally move up and down. Volatility is high when the price changes rapidly over a short period of time.

Liquidity

Is the ability to convert an asset into cash quickly enough without suffering slippage or loss in value. Liquidity is usually dependent on the availability of ready market participants to fill the other side of the transaction.

Dollar Cost Averaging

Investing a fixed amount of money at regular intervals over a period of time regardless of the share price. This is a smart investing strategy as it avoids trying to pick tops and bottoms in the markets.

Expense Ratios

Refers to annual fees paid for professional management of your money. It usually includes management fees, administrative fees, and other fees. High expense ratios can cut deep into overall returns investors make on their investments. Minimizing the costs of investment over the course of your investing life can mean the difference between average and above-average returns.